Posts Tagged ‘cash’

The new defensives- drugs & health care

Thursday, October 1st, 2009

Conventionally, if investors want to be at the most ‘defensive’ (i.e. not take any risk) for their investments, there are no better places than US Treasury bonds. The US is the keeper of the world reserve currency and their Treasury bonds are backed by the full faith and creditworthiness of the US government. By definition, the US government can never default on its debt because it has the full powers of taxation on its people and as a last resort, crank up the monetary printing press of the world’s only reserve currency. In other words, the US Treasury bonds are the safest ‘cash’ an investor can ever get.

But the problem is, under the colossal weight of debt that the US government is going to face (see How is the US going to repay its national debt?) and the commitment of Ben Bernanke towards the idea of debasing the currency (see Bernankeism and hyper-inflation), the safest of ‘cash’ is no longer safe in real terms. The US government cannot technically default on its debt because it can always print money and repay them in continually depreciated dollars. The Chinese government are acutely aware of this (see Nations will rise against nations) and are earnestly diversifying their safest ‘cash’ into other forms of store of wealth. With interest rates effectively at zero (which is below the rate of price inflation) and likely to stay there for a considerable period of time (see Marc Faber vs Steve Keen in inflation/deflation debate- Part 2: Marc Faber?s view), even risk-adverse savers are forced to speculate if they want to preserve the purchasing power of their savings.

So, we have this ironic situation that the most risk-free investments (US Treasury bonds) are actually very risky (currency depreciation through debasement). For US-based investors, Marc Faber reckoned that they are better off risking their wealth in defensive stocks than risking it in ‘cash.’

The question is which sector is defensive?

One sector that Marc Faber has in mind:

Spot the error in Warren Buffett’s logic

Sunday, March 8th, 2009

In Warren Buffett’s latest shareholder letter, he said that,

Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long. Holders of these instruments, of course, have felt increasingly comfortable – in fact, almost smug – in following this policy as financial turmoil has mounted. They regard their judgement confirmed when they hear commentators proclaim ?cash is king,? even though that wonderful cash is earning close to nothing and will surely find its purchasing power eroded over time.

Currently, as we said before in Why are nothing-yielding US Treasuries so popular?,

One of the thing that confounds us is the fact that short-term US government bonds are yielding almost nothing. A 10-year US Treasury bonds yields a measly 2.79% while a 30-year bond yields 3.57%.

Therefore, on that paragraph alone, we agree with Warren Buffett. That’s the main idea of our earlier article, If you save, government will wage economic war on you. But assuming that this is true, what is the implication for investors? Did Warren Buffett mean that investors should shift from cash to stocks?

If the answer to the second question is “Yes,” we can’t help but notice a flaw in his logic here. We will turn over to our readers to spot the flaw at our discussion forum. The first person who spot it will be given a pat on his/her back and be quoted! 🙂

Hedging against deflation

Monday, October 6th, 2008

The recent nationalisations, collapses and runs on banks in the US and Europe brings a new dimension of economic uncertainty to many people. The last time such things occur in the developed Western world was during the Great Depression in the 1930s. For this current generation of economists, financial analysts and money managers, a credit crisis is something that is supposed to occur only in textbook studies of the past. But recent financial market events brought such abstract history into real life. Suddenly, the idea that cash is no longer safe is a rude surprise for many. If cash is no longer safe, then where else can you hide?

This is what is technically called “deflation.” Deflation is not as simple as just falling prices. It is, as we explained in Will deflation win?,

A falling money supply is the definition of deflation, for which the symptoms will be falling asset prices, which if prolonged enough, will lead to falling consumer prices. But before we go off to celebrate falling prices, remember that this is an evil type of deflation because it is the type that is associated with bad debts, bankruptcies, unemployment, falling income, bank runs and so on.

We recommend that you read our guide, What is inflation and deflation? for more information about this topic.

So, if you are particularly concerned about deflation, how should you protect yourself? As we said before in Should you hold gold or cash in times of deflation?,

You see, the ?cash? that you had deposited in a bank is an asset to you but a liability to the bank. In times of severe economic conditions (e.g. during the Great Depression), can your bank honour its liabilities? If it can?t, then your ?cash? is in grave danger.

The key thing to remember is that as long as your asset is a liability of someone else (e.g. bank), you have a counter-party risk. If your counter-party defaults, your asset is gone. In this evil kind of deflation, counter-party default is the greatest risk to your wealth. Therefore, there is only two ways to protect yourself:

  1. Choose your counter-party wisely.
  2. Keep your wealth in a physical form such that it is nobody else’s liability.

We will first explain point (1). Basically, the only supposedly risk-free counter-party is the government because it has the executive power to tax and print money (note that we used the word “supposedly”- the Russian government defaulted on its bonds in 1998). If you store your wealth in the form of government debt (e.g. Treasury bonds), you will be guaranteed a periodic payment from the government. As we explained before in Measuring the value of an investment,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

In times of deflation, government bonds will be so highly sought after that its free market value will rise. Consequently, its yield (rate of return) will fall. On the flip side, government bonds are completely useless during inflation. In times of hyper-inflation, government bonds are as good as toilet paper.

Now, point (2) is already explained in Should you hold gold or cash in times of deflation?. But we would like to add a few more points:

  1. Gold was an excellent hedge during the days of the Great Depression because the US was still under a gold standard. The government would print a specific amount of US dollars to buy the gold that you presented to them. As we quoted Wilhelm R?pk in Which industry?s profitability grew as the Great Depression progressed?, the gold mining industry prospered during the Great Depression because

    So long as there exists at least one country [the US] on a full gold standard, an essential condition of which is freedom to buy gold from or sell gold to the central institution at a fixed price, there is literally an unlimited demand for the commodity at that price. In other words, not only is a minimum price for the product of the industry guaranteed, but there is, besides, no limit to the amount the market will take.

  2. The case for physical gold as a deflation hedge is weakened if the government insures bank deposits. In the US, the FDIC insures up to $100,000 of bank deposits. In Australia, there is NO government deposit insurance.
  3. But if for whatever reason, you (1) distrust the government’s deposit insurance, (2) have more than the amount that is insured by the government, (3) believes that the government will print lots of physical cash to provide for cash withdrawals in a bank run, (4) put a freeze on cash withdrawals to prevent bank runs, (5) government does not insure bank deposits (e.g. Australia), (6) can only trust storing your wealth in tangible form (6) etc, there is still arguably a case for holding gold as a hedge against deflation.
  4. The US government outlawed gold ownership during the Great Depression. It may happen again this time.

Liquidity?Global Markets Face `Severe Correction,’ Faber Says

Tuesday, January 16th, 2007

Marc Faber, the legendary contrarian, predicted the 1987 stock market crash, had this to say. He singled out emerging markets for a correction, especially Russia, followed by China (see China is tightening liquidity) and India. In that correction, all asset markets will be affected.

What is the rationale behind Faber?s prediction?

First, we have to understand the concept of ?liquidity.? What is ?liquidity?? There are other meanings for the word ?liquidity?, but for the purpose of this article, we will stick to the quick and dirty definition of ?liquidity? being ?money? in the financial system. Now, how do we define what is the ?money? in liquidity? Traditionally, ?money? is just what it is?cash and deposits. But today, with the advances in finance, ?money? is no longer as easily and clearly defined as before. As a result, money substitutes are becoming proxies for money and playing a much more important role in global liquidity than before. Examples of money substitutes include credit (e.g. mortgage-backed securities) and derivatives.

Now, what has liquidity got to do with the asset markets?

As you may have noticed, stock markets around the world are in record high territories. What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

How is it possible for liquidity to be crunched?

The problem with liquidity is that most of the ?money? in it is made up of money substitutes, most notably derivatives. Today?s modern financial system is such that when the central bank ?creates? money, money substitutes get spawned multiple times. The outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom. The financial assets between the apex and bottom include cash deposits (spawned and multiplied from hard cash through the fractional reserve banking system) and credit (e.g. securitised debt). In such a liquidity pyramid, the values of financial assets at the lower part of the pyramid are derived from and backed up by the financial assets above it. Since much more of global liquidity are composed of ?money? in the lower part of the pyramid, any contraction in the upper parts of the pyramid will result in a multiplied contraction in the lower parts. If the liquidity contraction is severe enough, asset prices will fall precipitously, which in turn may trigger even more contraction in liquidity. This is called a ?market crash.?

Thus, as long as the central bank can influence the increase in liquidity into the financial system, asset prices will rise. If for whatever reason, liquidity contract severely enough, asset prices will collapse.

The question is, are we now ripe for a contraction in liquidity?

Entrenched perception on the value of paper money

Monday, December 11th, 2006

Not long ago, we advised someone to buy gold as a hedge against inflation. That person?s reaction was, ?But gold prices had already doubled from a few years ago!?

As we think about that person?s reaction, we realised that people?s perception on the value of gold had changed immensely over the course of centuries. Two hundred years ago, people would rather trust gold much more than paper money. After all, paper money were just warehouse receipts for gold, which may well be forged or quantitatively inflated (this is, strictly speaking, fraud). Gold, on the other hand, had been selected by the free market over the course of centuries as the most reliable medium of money. It was considered far more reliable than paper because there was (and is) no way for anyone to easily inflate the supply of it at will (other than mining for it, which require significant time and effort).

Today, people?s entrenched perceptions are completely different. Somehow, by some strange reason, paper currency (with today?s technology, they can exist in the form of digital information) is mistakenly seen to be the more reliable store of value. It has come to the point that even the value of gold is measured in terms of paper currency. As we said before in How is inflation sabotaging our ability to measure the value of things?, how can we measure the value of something by using a yardstick that is as elastic as paper currency?

Now, since the gold prices had doubled from a few years ago, will it be subjected to the law of gravity and return to where it was? There is nothing to prevent gold from obeying (or disobeying) this ?law? but fundamentally, if this ever happen, the market will be behaving even more irrationally that it is right now. Think about it: if the quantity of paper currency (including credit, money substitutes, deposits, etc) is growing at a rate that far outstrips the rate of increase in the quantity of gold by a colossal margin, then the fundamental value of paper money relative to gold has to continue to fall significantly. Today, gold prices still far undervalue the fundamental worth of gold.

If we consider the way central banks around the world are grossly inflating the supply of paper currencies, we cannot help but feel that it is more risky to hold cash in the long run.